Are Gold and the SP 500 Behaving Logically or Irrationally?

Back on August 7th the S&P 500 was in the midst of a panic induced selloff
and the bulls were running scared. Prices were collapsing and the bulls were
racing to the exits. In the following weeks, piles of money flew out of equity
mutual funds as the retail investors rang the register and pulled their money
out near the lows which seems to be a regularly recurring event.

While most market participants were clearly panicking, I was sitting back
watching the market push lower with complete focus on being ready to initiate
long positions near the lows. I sent out multiple warnings to members of my
service to raise cash and reduce risk. I sat in cash and watched the madness
unfold in real time.

Admittedly I did not expect the selloff to be as severe as it was and unfortunately
I did not get involved with any short exposure. However, my focus is always
forward looking and opportunities will present themselves again and protecting
my trading capital is always my primary focus.

My article that went out August 8th was focused on downside momentum in the
marketplace as well as key areas where I expected price action to hold at support.
I was expecting the S&P 500 to find support around the 1,130 price level.
I will be the first one to admit I am not one for making bold predictions,
but I'm not scared to identify key long term support levels which have the
tendency to mark bottoms in price action.

While price ultimately undercut my 1,130 target price level on the S&P
500, the following day a giant reversal bar formed which captured my interest
and on August 10th I entered long positions with tight stops below the recent
lows and members and I were quickly rewarded. I closed the remainder of the
trade today and locked in a 32% return based on maximum risk in essentially
1 week using a basic option strategy which levered up my position.

Now I find myself with very little exposure and I'm pondering what to do.
First of all, a quick glance at the short term momentum charts illustrates
that price action is still extremely oversold. However, oversold conditions
could worsen further potentially. The chart below illustrates the amount of
stocks trading above their 20 period moving averages:

It is obvious that price action in the S&P 500 is clearly oversold and equities
have considerable room to rally. However, I would point out that oversold
conditions can be worked off as function of the passage of time and not just
higher prices. I continue to believe that we will see the S&P 500 test
the 1,220 price level and will likely move on to the 1,250 area. If price
action can work above the 1,250 price level the neckline of the head and
shoulders pattern will act as a key resistance area. The daily chart of the
SPX is shown below:

The key levels outlined correspond with major support areas that are either
carved out by previous pivot lows or through Fibonacci retracement levels.
At the very least, I expect price action in the S&P 500 index to test near
the 1,220 price level as it will mark a .500 Fibonacci retracement area.

I would not be at all shocked to eventually see the neckline of the head and
shoulders pattern backtested to verify resistance. The head and shoulders pattern
that helped propel prices lower is clear when looking at the weekly chart.
I first wrote about the pattern back on July 8th and presented the following
chart:

It is entirely plausible that Mr. Market thrusts lower from here to shake
out longs. If that scenario plays out it could potentially carve out a double
bottom or another basing pattern which would give active traders another entry
point to get long. I think we are weeks from having a possible test of the
recent lows on the S&P 500 as it is going to take the broad marketplace
quite a while to digest the selloff and work off oversold conditions as a function
of time and/or price.

Price action would be healthier if we pulled back a bit here before attempting
to attack the resistance at the key 1,200 price level on the S&P 500. If
prices continue to race higher in a short period of time I would consider the
price action to be more of a warning that lower prices are around the corner.

While anything could happen, I believe that the S&P 500 will test the
recent lows which need to hold desperately. I want to be a bull very badly,
but right now unfortunately I cannot be bullish because a variety of indicators
and analysis suggests that lower prices may await us.

By now most readers recognize the monster bull market that gold and silver
have enjoyed for nearly a decade. I do not intend to provide a history lesson,
but during the last equity selloff investors and traders alike fled to Treasuries
and the yellow metal for safety while nearly every other asset class sold off.
Gold put in a new all-time high on August 11th and price quickly sold off.

Since then we have seen gold climb back up and at this point in time it appears
to be poised to test the recent highs. Some market pundits say gold is in a
bubble while others say prices will work higher. In my estimation as long as
the Federal Reserve has loose monetary policy gold prices will continue higher
over the long term. At this point in time it does not appear likely that the
Federal Reserve will tighten monetary policy until after the election at the
very earliest.

Instead of arguing the economics behind gold prices and the inflation/deflation
debate, I am more interested in where price action may be headed. At first
glance on the daily chart of gold futures it could be said that gold has accelerated
significantly higher in a short period of time. There are plenty of traders
that believe gold has gotten ahead of itself and desperately needs a strong
correction to shake out weak ownership.

Yet again, I find myself expecting to see gold selloff in what could play
out as a double top on the daily chart. I am going to be watching the price
action closely looking for a possible entry to take advantage of lower prices.
At the same time, I am not willing to go charging in until I see some confirming
signs that gold prices will head lower.

If gold prices push above the recent highs with additional momentum gold will
trade higher yet. The next few days should be very telling as a large move
could be setting up in the yellow metal in the near term. The daily chart of
gold is shown below:

While the daily chart clearly illustrates the potential for a double top to
emerge, the weekly chart has a more parabolic look to it. If a significant
correction in the price of gold sets up for traders to take a longer term short
trade, then a major reversal or topping pattern should come into focus in the
next few weeks.

While a short term trade to take advantage of lower prices in gold might produce
some fast money, longer term traders need to be patient and let gold confirm
lower prices before getting involved. The weekly chart of gold is shown below:

Ultimately I do believe we need to see a healthy pullback in gold that works
off some of the overbought conditions that are present in the price action.
If investors continue to view gold as a safety trade it is obvious that prices
could continue higher based on uncertainty coming out of the sovereign debt
crisis going on in Europe. As of right now, it appears gold could go either
way but probability favors the downside.

Logically it would make sense that if the S&P 500 rallied gold would selloff.
Unfortunately Mr. Market rarely embarks upon the logical until he has convinced
enough market participants to behave irrationally. It should be interesting
to see what Mr. Market has up his sleeve this time.

J.W. Jones is an independent options trader using multiple forms of analysis
to guide his option trading strategies. Jones has an extensive background
in portfolio analysis and analytics as well as risk analysis. J.W. strives
to help traders that are missing opportunities trading options. He also commits
to writing content which is not only educational, but entertaining as well.
Regular readers will develop the knowledge and skills to trade options competently
over time. Jones focuses on writing spreads in situations where risk is clearly
defined and high potential returns can be realized.

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